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4. Taxation of Outbound Direct Investment

Introduction

4.1   Outbound direct investment can result in significant economic benefits for Canadians, including efficiency gains and greater productivity as described in Chapter 2. These benefits underlie the principle set out in Chapter 3 that Canada’s outbound taxation rules should be competitive when compared with those of Canada’s major trading partners. This principle is central to the discussion and recommendations in this chapter.

4.2   The basis of Canada’s current outbound taxation system was a part of the 1972 tax reform package and has been in place since 1976. Although changes have been made over the years, the rules’ basic features remain the same. The Panel believes this system has served Canada well in many respects.

4.3   In this chapter, the Panel discusses our analysis and conclusions regarding how the competitiveness of Canada’s system of outbound taxation could be improved by broadening the current exemption system. The Panel also identifies other changes needed to update the system and maintain the integrity of Canada’s tax base once a broader exemption system is adopted. Specifically, the Panel addresses the taxation of foreign-source income in the following areas:

• active business income, particularly when earned indirectly through foreign affiliates,
• capital gains arising on dispositions of shares of foreign affiliates,
• foreign passive income and its treatment under Canada’s anti-deferral regimes, and
• expenses incurred to earn foreign-source income, particularly interest expense.

Alternatives for taxing foreign-source income

4.4   Broadly speaking, countries have three principal choices in how they tax foreign income earned through foreign entities:

• Accrual or Worldwide Basis of Taxation
• Deferral with Credit
• Full Exemption Method.

Accrual or Worldwide Basis of Taxation

4.5   Under the accrual or worldwide basis of taxation in its purest form, all domestic and foreign-source income earned directly or indirectly by a taxpayer is taxable in the taxpayer’s country of residence on an accrual basis (that is, as it is earned) regardless of whether the foreign income is active or passive or whether the income is repatriated to the home country. A tax credit is provided by the resident country for any underlying foreign tax paid in respect of such income.

Deferral with Credit (the “Credit Method”)

4.6   Under the Credit Method, the taxation of foreign active business income earned indirectly through foreign corporations is deferred until such income is repatriated to domestic shareholders. A tax credit is allowed for any underlying foreign income and withholding tax payments related to the income. This method is currently employed by the United States, the United Kingdom and Japan, among others.

Full Exemption Method (also known as the “Territorial Method”)

4.7   Under a full exemption system, all foreign income, including capital gains on the sale of assets and shares of foreign companies, is exempt from domestic taxation when earned and when paid as a dividend to domestic corporate shareholders. Such income is subject to tax only in the jurisdiction in which it is earned, although domestic tax may arise when the income is later distributed by the domestic corporation to an individual shareholder. Most countries employ a full exemption system only for foreign active business income; passive income earned indirectly through certain foreign corporations is taxed on an accrual basis. In short, under a full exemption system, foreign-source income is either taxed domestically as it is earned (because it is passive income) or not at all.

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Canada’s current system

4.8   The current Canadian system for taxing foreign-source income has attributes of each of the above methods.

4.9   Income earned directly by a Canadian taxpayer from a branch in a foreign jurisdiction is taxed on a current basis, with a foreign tax credit available for any foreign tax paid on the income.

4.10   Income earned indirectly by a Canadian taxpayer through a foreign affiliate is taxed under a special set of rules known as the foreign affiliate regime. These rules apply where the Canadian taxpayer, either alone or together with related persons, holds at least a 10 percent direct or indirect interest in any class of shares of a foreign corporation (a “foreign affiliate”). The paragraphs that follow discuss the key features of the current foreign affiliate system.

Foreign active business income

4.11   Under the current foreign affiliate system, active business income earned by a foreign affiliate of a Canadian corporation is not taxable in Canada until such income is repatriated as a dividend to the corporation (except as noted in paragraphs 4.13 and 4.15).

4.12   A dividend from active business income earned by a foreign affiliate is exempt from Canadian tax if the affiliate is resident and carries on its business in a country with which Canada has a tax treaty (a “Treaty Country”). Under recently enacted changes for taxation years beginning after 2008, the same treatment applies to dividends from active business income earned by a foreign affiliate in a country with which Canada has a comprehensive Tax Information Exchange Agreement or TIEA (a “TIEA Country”). If an affiliate is not resident or does not carry on its business in a Treaty or TIEA Country, the Credit Method applies to the income.

4.13   Also under these new rules, if Canada does not conclude a TIEA with a country within five years after the beginning of negotiations to do so, the active business income earned by a foreign affiliate in that country will be treated as foreign accrual property income (see below).

Foreign accrual property income

4.14   Under Canada’s foreign accrual property income (FAPI) rules, a Canadian resident shareholder is taxable on an accrual basis on amounts related to certain types of income earned by “controlled foreign affiliates”,²⁶ with relief provided for any foreign tax paid on the income. FAPI includes passive income, such as interest, dividends (except dividends from other foreign affiliates), royalties and 50 percent of capital gains realized from the sale of property that is not “excluded property”. A foreign affiliate’s excluded property includes its property used to earn active business income and shares of another foreign affiliate where all or substantially all of the fair market value of the property of that other foreign affiliate is attributable to excluded property.

4.15   Additionally, under the “base erosion rules”, income from certain business activities is treated as FAPI. Other rules treat income that would otherwise be active business income as FAPI where the business generating the income is not conducted principally with arm’s-length persons or does not employ more than five full-time employees. Special exceptions to the FAPI rules apply to certain payments between certain foreign affiliates.

4.16   FAPI earned by a non-controlled foreign affiliate is subject to Canadian tax under the Credit Method.

Capital gains on sales of foreign affiliate shares

4.17   Fifty percent of capital gains realized by Canadian residents on the disposition of shares of a foreign affiliate is subject to Canadian income tax.²⁷

4.18   Fifty percent of capital gains realized by a foreign affiliate on the sale of shares of another affiliate is considered to be FAPI unless the shares are excluded property. If such gains are from the disposition of excluded property, 50 percent of the gain is subject to Canadian tax when the proceeds are repatriated to Canada. Capital gains on the disposition of assets used in an active business in a Treaty or TIEA Country are fully exempt.

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Assessing Canada’s treatment of foreign active business income

4.19   In our consultation paper, the Panel suggested that our review should focus on whether Canada should move to a broader or full exemption system for taxing foreign active business income earned directly or indirectly by Canadian corporations. Our consultations and benchmarking research confirmed that this focus is appropriate.

4.20   The Panel revisited the alternative methods for taxing foreign active business income and concluded that an exemption system is the right choice for Canada. Our analysis of the other alternatives is set out in Appendix C. An exemption system is more consistent with the goal of encouraging the competitiveness of Canadian businesses operating globally and is also in step with the provisions many countries have in place or propose to adopt.²⁸

4.21   The Panel believes that the exemption of foreign active business income earned by a foreign affiliate should be viewed as the norm for Canadian tax purposes.²⁹ Ours is a territorial view which asserts that such income should not be considered part of Canada’s tax base. This view is consistent with current international norms — and the reality that little Canadian tax is collected on foreign active business income. The balance of this section reviews the aspects of Canada’s system that led the Panel to conclude that Canada should broaden its current exemption system.

Tracking surplus balances of foreign affiliates

4.22   In our review, the Panel heard that one of the predominant issues regarding Canada’s current exemption system is the complexity associated with tracking surplus balances.

4.23   Canada’s system for taxing foreign active business income earned through foreign affiliates has elements of both the Credit Method and Full Exemption Method. Some foreign profits (“surplus”) are exempt on repatriation (“exempt surplus”), while others are eligible for relief for the foreign tax paid on the income from which the dividend was paid (“taxable surplus”). As a result, businesses must track all foreign earnings and account for them according to their treatment on repatriation to ensure they are appropriately taxed.

4.24   A business can compute its earnings for surplus purposes, for the most part, using the tax rules of the country where the foreign affiliate is resident and the country where the profits are generated. However, businesses must navigate through the many exceptions and special provisions within these rules. For example, some of these rules apply to specific transactions like capital gains. Depending on the transaction’s character, the gain or loss needs to be accounted for separately and allocated to the appropriate surplus account. In certain circumstances, a business may be required to compute certain gains or profits under both foreign and Canadian tax rules, and using Canadian or a foreign currency, adding more complexity.

4.25   Businesses told the Panel that maintaining up-to-date exempt and taxable surplus balances is complicated, time-consuming and often overwhelming for a number of reasons:

• Preparing and filing foreign tax returns, which is the starting point for computing surplus balances, takes time. In some cases, foreign tax returns are not filed until many months after the end of the affiliate’s taxation year.
• Surplus balances must be updated for changes arising from audits by foreign tax authorities. Sometimes, these changes are not made until after the affiliate has paid dividends based on previously calculated surplus balances, which can lead to adverse tax results. Information received after-the-fact or changes to foreign tax laws can also cause surplus balance adjustments.
• Businesses may have difficulty obtaining the information they need to determine the tax basis of their assets under the Canadian tax rules (for example, to calculate capital gains).
• The surplus of a foreign affiliate must be recomputed when there is a change in the ownership of the foreign affiliate, and the surplus implications of each reorganization involving a foreign affiliate must be re-analyzed if its earnings are adjusted or a previous year’s surplus amounts revised.
• Accounting for different foreign currencies can compound the complexity and produce unintended results.

4.26   The surplus tracking requirements create a significant compliance burden for Canadian businesses (especially small and medium-sized businesses) and generate little, if any, Canadian tax revenue (see paragraph 4.30). Canada’s rules governing outbound investment through foreign affiliates would be greatly simplified if taxpayers did not have to maintain such accounts.

4.27   Eliminating surplus tracking would relieve the CRA of the significant administrative burden of reviewing taxpayers’ surplus calculations when dividends are paid to Canadian corporate shareholders. Instead, the CRA could focus more of its limited resources on whether taxpayers are properly computing FAPI of an affiliate and applying transfer pricing rules in a way that does not understate domestic active business income (which is taxable) or overstate foreign active business income (which is exempt).

Dividends paid by foreign affiliates

4.28   The purpose of tracking the two surplus pools is to identify which dividends are exempt and which dividends are subject to Canadian tax.³⁰

4.29   For many years, the Canadian tax system has granted an exemption for foreign active business income earned in countries with which Canada has a tax treaty. For the past 20 years, the portion of stock of Canada’s direct investment abroad in treaty countries has ranged between 87 percent and 94 percent.³¹ Based on the table below, of the total amount of exempt and taxable surplus dividends paid by foreign affiliates of Canadian companies between 2000 and 2005, about 92 percent were exempt.

4.30   The Panel was unable to determine how much Canadian tax was collected on the eight percent that were taxable surplus dividends. During the Panel’s consultations, businesses and tax practitioners were united in the view that the amount collected is low.

4.31   The conclusion the Panel drew was that Canada’s system already largely exempts foreign active business income earned by foreign affiliates.

4.32   In addition to the benefits that will arise from a simpler system, moving to a broader exemption system could also facilitate repatriation of foreign profits to Canada. These profits could then be redeployed more efficiently by Canadian businesses. While little tax is collected under the current system (and most earnings can be repatriated tax-free), some foreign affiliate earnings are not repatriated probably because of the inherent tax cost of doing so. These earnings may be redeployed outside Canada but perhaps not in the most advantageous way. Moving to a broader exemption system would eliminate such inefficiencies, with no significant fiscal consequences.

Conclusion

4.33   The Panel has concluded that Canada should formally adopt a broader exemption system for foreign active business income earned through foreign affiliates for the following reasons:

• A broader exemption system would be simpler, reducing the compliance burden for Canadian businesses and the administrative burden for the CRA.
• Broadening the exemption system would be revenue-neutral for the government, as dividends from foreign affiliates are rarely taxed under the current regime.
• A broader exemption system could facilitate repatriation of foreign profits, generating economic benefits for Canadian businesses and their owners.
• Our benchmarking research shows that taxing active business income at its source is consistent with the tax policies (or policy direction) of most other industrialized nations.
• As noted in paragraphs 3.13 to 3.14, concerns that formally adopting a broader exemption system would cause a migration of jobs or investment from Canada are not well supported.

Recommendation 4.1: Broaden the existing exemption system to cover all foreign active business income earned by foreign affiliates.

4.34   One implication of this recommendation is that all dividends from foreign affiliates would be exempt. However, as described starting at paragraph 4.79, certain passive income of foreign affiliates would continue to be taxed currently under Canada’s anti-deferral regimes.

Tax Information Exchange Agreements and Canada’s exemption system

4.35   As noted in paragraph 4.12, Canada’s current exemption system for foreign active business income earned by a foreign affiliate extends to such income earned by a foreign affiliate in a TIEA Country for taxation years beginning after 2008. However, if Canada does not enter into a TIEA with a country within five years following the initiation of negotiations to do so, the active business income earned by a foreign affiliate in that country will be treated as FAPI.

4.36   TIEAs originate from the OECD’s work on Harmful Tax Competition, which identified the lack of effective exchange of information as a key criterion in determining harmful tax practices. The 2002 OECD Model Agreement on Exchange of Information on Tax Matters set the standard.³² TIEAs establish the terms under which contracting states help each other administer and enforce their domestic tax laws through the exchange of relevant information.

4.37   The terms of a TIEA and how it is used are defined by the contracting states. A TIEA usually contains provisions that:

• identify which taxes imposed in each country are subject to the agreement,
• describe how exchanges of information will occur,
• prescribe when a request for information may be declined, and
• treat any information received under the TIEA as confidential.

4.38   For countries with which Canada has no tax treaty, TIEAs are important to ensure that Canada can obtain sufficient information to enforce its tax laws and combat tax evasion.

4.39   A consequence of the Panel’s Recommendation 4.1 is that the exemption system for foreign active business income earned by foreign affiliates should no longer be linked to tax treaties or TIEAs. The Panel believes there are sound reasons to detach the exemption system from tax treaties and TIEAs.

4.40   Over the years, some commentators have maintained that Canada’s exemption system was conceived as a proxy for the Credit Method. Where a country’s tax system was comparable to Canada’s, the Credit Method would generate no further Canadian tax revenue in Canada and so it was simpler to exempt dividends from Canadian tax. On this view, tax treaties were considered a reasonable way to evaluate whether the tax regimes of other countries were comparable to Canada’s.

4.41   However, although under pre-2008 rules a foreign affiliate’s income had to be earned in a Treaty Country for dividends paid to a Canadian corporation to be entitled to exemption, the income was not required to bear tax at a level similar to the rate that would apply in Canada. Over the years, Canada has entered into tax treaties with low-tax countries and with countries that do not have comparable tax systems. Canada will probably continue to pursue tax treaties and TIEAs with such countries in the future. These developments counter the view that the current exemption system is a proxy for the Credit Method.

4.42   Additionally, Canada has always sought something in return for granting exemption for foreign active business income. In earlier years, granting exemption was meant to induce the other country to enter into a comprehensive tax convention with Canada. Now that Canada has 86 treaties, this incentive no longer seems necessary. With the TIEA initiative, the government seeks access to information and is prepared to grant an exemption for active business income in exchange for it.

4.43   Obtaining TIEAs is important for the Canadian tax system. However, the Panel believes that, like tax treaties, TIEAs should not be linked to Canada’s exemption system. To preclude businesses from benefiting from the simplicity and other gains of a broader exemption system because a non-Treaty Country chooses not to negotiate a TIEA with Canada seems inappropriate.

4.44   The Panel also heard concerns about the current rule that treats active business income as FAPI if Canada does not enter into a TIEA with a country within five years of starting negotiations. The Panel was told that this rule puts an unfair onus on businesses to influence the local government to secure a TIEA. The Panel shares these concerns.

Recommendation 4.2: Pursue tax information exchange agreements (TIEA) on a government-to-government basis without resort to accrual taxation for foreign active business income if a TIEA is not obtained.

4.45   The Panel believes the government should monitor international developments and participate in discussions regarding jurisdictions that may be viewed as uncooperative in the sharing of information that is needed for countries like Canada to enforce their tax laws.

Capital gains arising on dispositions of foreign affiliate shares

4.46   As noted at paragraph 4.17, 50 percent of capital gains realized by Canadian residents on the disposition of shares of a foreign affiliate is subject to Canadian income tax. A capital gain realized by a foreign affiliate on the sale of shares of another foreign affiliate is subject to Canadian tax on a current basis unless the shares are excluded property. Whether the foreign affiliate shares are excluded property or not, 50 percent of the gain is included in the disposing affiliate’s exempt surplus and the other 50 percent in taxable surplus.

4.47   Conversely, 50 percent of capital losses realized by Canadian residents on the disposition of shares of a foreign affiliate may be available in certain circumstances to shelter income from Canadian tax. A capital loss realized by a foreign affiliate on the sale of shares of another foreign affiliate may reduce its exempt and taxable surplus.³³

4.48   In a system that exempts foreign active business income earned by foreign affiliates, consideration should be given to the appropriate tax treatment of capital gains and losses realized by a Canadian shareholder or a foreign affiliate on a disposition of the shares of another foreign affiliate where the shares derive all or substantially all of their value from assets used principally to earn active business income (referred to in this section and in Appendix B as “active business assets”).

4.49   One view is that capital gains are passive in nature and similar to investment income, and so they should remain taxable. Another view is that exempting capital gains arising on the sale of shares of a foreign affiliate is appropriate if the income generated by the affiliate is also exempt from Canadian tax; that is, if the capital appreciation inherent in the share value represents the present value of the affiliate’s future active business earnings stream. This view also accords with the treatment that would occur if the foreign affiliate’s active business assets were sold, rather than its shares, and the proceeds were paid as a dividend to Canada. In a system that exempts capital gains, capital losses from dispositions of the same types of property should be denied.

4.50   The Panel’s benchmarking research confirms that most countries that exempt dividends received from a foreign affiliate from domestic taxation also exempt capital gains realized on a disposition of the shares of the foreign affiliate. The tax regimes of Australia, France, Germany, Italy, the Netherlands and Sweden each provide for some level of exemption, in certain circumstances, for dividends from foreign corporations and capital gains on foreign corporation shares. New Zealand and the United Kingdom have proposed or are considering similar regimes.

4.51   Practically, in moving to a system that exempts capital gains on dispositions of foreign affiliate shares, little tax revenue should be at risk for the following reasons:

• Foreign affiliates are often held through foreign holding companies so that such dispositions are not immediately subject to tax in Canada.
• For the reasons noted earlier in this chapter, where a foreign affiliate realizes a capital gain from the disposition of another foreign affiliate’s shares, the portion of the gain that would otherwise become taxable surplus is rarely repatriated to Canada. If it is, Canadian tax is rarely payable on those distributions.

Conclusion

4.52   The Panel believes that Canada’s exemption system should be extended to capital gains realized by Canadian shareholders on dispositions of foreign affiliate shares (and capital gains realized by foreign affiliates on the sale of shares of other foreign affiliates) where the shares derive all or substantially all of their value from assets used or held principally to earn active business income. The Panel reached this conclusion for the following reasons.

• Exempting capital gains arising on the sale of shares of a foreign affiliate is appropriate because the affiliate’s income would also be exempt from Canadian tax. This treatment is consistent with the view that foreign active business income should be exempt from Canadian income tax.
• The Panel’s benchmarking research confirms that most countries that exempt dividends received from a foreign affiliate from domestic taxation also exempt the capital gain realized on a disposition of the shares of the foreign affiliate.
• Little tax revenue should be at risk if capital gains realized on dispositions of foreign affiliate shares were exempt.

4.53   At first glance, exempting gains on the sale of foreign affiliate shares while taxing gains on the sale of Canadian company shares may seem inconsistent. This difference can be accepted on the basis that the current rules are out of step with most other countries that have exemption systems³⁴ and that this approach could eliminate another aspect of surplus tracking, resulting in a much simpler system for businesses and the CRA.

Recommendation 4.3: Extend the exemption system to capital gains and losses realized on the disposition of shares of a foreign affiliate where the shares derive all or substantially all of their value from active business assets.

Related issues

4.54   The Panel has identified certain technical and policy issues that the government should address in moving to a broader exemption system that exempts capital gains arising on sales of foreign affiliate shares.

Excluded property

4.55   As currently defined, “excluded property” is limited to property of a foreign affiliate (not of a Canadian taxpayer), which is used or held principally for the purpose of earning active business income. It also includes shares of another foreign affiliate where all or substantially all of the fair market value of the property of the other foreign affiliate is attributable to excluded property. Property that is not excluded property is referred to in this report as “non-excluded property”.

4.56   To implement Recommendation 4.3, the “excluded property” definition could be extended to include shares of a foreign affiliate held by a Canadian corporation (i.e., not only shares of a foreign affiliate held by another foreign affiliate) so that the exemption for capital gains from the disposition of foreign affiliate shares could then be referenced to shares that are excluded property.

Non-excluded property

4.57   The Panel does not believe that full exemption from capital gains taxation under a broader exemption system should extend to shares of foreign affiliates that do not derive all or substantially all of their value from active business assets. Such gains should remain taxable; otherwise, Canada’s tax base would be exposed to the possible loss of passive income that should be subject to Canadian tax.

4.58   The government should consider what results are appropriate where the all-or-substantially-all test is not met. For example, Australia has adopted an approach of taxing only the pro-rata share of the gain that relates to non-excluded property. Canada could adopt a similar approach which would exempt the portion of the gain that relates to active business assets on the basis that the same result would occur had active business assets been sold by the foreign affiliate and the proceeds distributed as an exempt dividend.

4.59   See Appendix B for discussion of several additional issues related to a capital gains exemption for certain foreign affiliate shares.

Definition of “foreign affiliate”

Canada’s approach

4.60   The benefit of foreign affiliate treatment under the current Canadian system is the availability of an exemption or relief for the underlying foreign tax paid by the foreign affiliate in respect of dividends received by the Canadian shareholder. The disadvantage of such treatment is that where a foreign affiliate becomes a controlled foreign affiliate, its FAPI is taxed in Canada on an accrual basis.

4.61   A foreign corporation is a foreign affiliate under Canada’s rules if:

• the Canadian investor has a direct or indirect interest of at least one percent in any class of shares of the foreign corporation, and
• the aggregate of the Canadian investor’s interest and the highest direct or indirect interests held by persons related to the investor in any class of shares of the foreign corporation is at least 10 percent.

Other countries’ approaches

4.62   None of the countries studied in the Panel’s review employ a test based on the fair market value of the shares owned to determine foreign affiliate status. Other countries, including the United States, the United Kingdom and Australia, use a test based on votes attributed to the shares owned. Some countries seem to substitute value in such tests with a concept similar to Canada’s concept of “paid-up capital” (i.e., the amount of a corporation’s share capital that has been fully paid by shareholders). Presumably, this approach would produce a more consistent result than an approach based on fair market value.

4.63   Some countries, such as Sweden and the Netherlands, employ a flexible test whereby an investment that meets one of several conditions is considered a non-portfolio investment and is thus eligible for the dividend exemption. For example, such a test could use a threshold of 10 percent of votes or share capital.

4.64   Of the countries studied that have a form of exemption system, the percentage thresholds vary from five to 15 percent, with many of these countries settling on 10 percent.

4.65   Canada’s current foreign affiliate rules employ a 10-percent-votes-and-value test to establish which affiliates can make certain types of payments to other affiliates that will be treated as active business income of the other affiliates and added to their exempt surplus.³⁵

Conclusion

4.66   Given the Panel’s recommendation to broaden the exemption system to cover all dividends from foreign active business income and capital gains on dispositions of shares of foreign affiliates that are excluded property, the current ownership threshold may require review, especially in light of the thresholds in place in other countries.

4.67   Canada’s FAPI regime taxes passive income of a “controlled foreign affiliate” on an accrual basis. However, a foreign company cannot meet the “controlled foreign affiliate” definition unless it is first a foreign affiliate. Tightening the requirements to achieve foreign affiliate status could open opportunities for arrangements that inappropriately avoid the FAPI regime because the foreign corporation does not meet the definition of “foreign affiliate”.

4.68   However, the Act currently sets out both specific and general anti-avoidance rules to prevent tax avoidance schemes where foreign affiliate status is considered to have been achieved inappropriately. Since these provisions also apply where foreign affiliate and controlled foreign affiliate status are inappropriately avoided, they should act to deter such tax avoidance schemes.

4.69   The Panel notes that the Technical Committee on Business Taxation recommended strengthening the “foreign affiliate” definition so that “only foreign companies in which Canadian corporations have a significant equity interest can be considered as foreign affiliates.”³⁶ No legislative proposals were tabled to adopt this recommendation.

4.70   Raising the threshold for an investment to be considered a direct investment and thus an investment in a foreign affiliate could adversely affect the treatment of existing investments of Canadians in foreign corporations that currently qualify as foreign affiliates. The government should undertake thorough consultation and consider appropriate transitional rules before taking any action in this area.

4.71   If the government were to tighten the rules in this area, the Panel believes it would be most appropriate to take a flexible approach that would allow an investment to meet one of several tests (for example, 10 percent of either votes, share capital or value).

Recommendation 4.4: Review the “foreign affiliate” definition, taking into account the Panel’s other recommendations on outbound taxation, the approaches of other countries, and the impact of any changes on existing investments.

Related Issues

Application to other foreign entities

4.72   Under the current rules, only a foreign corporation can qualify as a foreign affiliate. This treatment presumes that active business is carried on only through entities that are corporations. In many countries, business can be conducted through entities or forms of association that are not corporations but are taxed as if they were. In some countries, using a corporation may not be the optimal or most tax-efficient form of association through which to conduct certain businesses locally. However, using the better form of association may have adverse Canadian tax consequences.

4.73   The Panel suggests the government consider amending the definition of “foreign affiliate” of a taxpayer resident in Canada to include any non-resident entity where the taxpayer and related persons hold equity interests in the entity that would be the equivalent of an interest in a foreign affiliate if the entity were a corporation and its equity interests were shares.

Income from foreign branches

4.74   Conceptually, there is no reason to tax foreign-source active business income earned through a foreign branch of a Canadian company differently than such income earned through a foreign affiliate. However, exempting a foreign branch’s active business income from Canadian tax would require complicated rules. For example, new rules would be required to tax the FAPI of the branch on an accrual basis.

4.75   In our consultations, the Panel did not discern any strong support for extending the exemption to foreign branch income, although it was widely agreed that such a move makes sense in theory.

4.76   The Panel believes that treating the foreign active business income of foreign branches and foreign affiliates more consistently is a desirable goal, but the practical difficulties involved currently outweigh the benefit of uniform treatment.

4.77   For these reasons, the Panel suggests no fundamental changes to the taxation of foreign branch income at this time.

4.78   Should the government decide to extend the exemption system to branches, the Panel also suggests that it work closely with the industries that would be most affected. The Panel suggests that, if such a system were adopted, the government consider allowing businesses to make a one-time, irrevocable election to opt into the new regime.

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Foreign accrual property income and Canada’s anti-deferral regimes

4.79   This section of the report addresses passive income earned indirectly through foreign corporations and other foreign entities.

Background — Canada’s current anti-deferral regimes

4.80   Certain Canadian tax rules aim to ensure that the Canadian tax base is not eroded by Canadian resident taxpayers transferring passive investments and certain business activities to foreign entities to avoid or defer the Canadian tax otherwise payable had the income been earned directly in Canada. These rules, which reflect the third principle described in paragraph 3.3, are known as “anti-deferral regimes”.

4.81   Because passive income is highly mobile, without such rules, Canadian businesses could easily convert domestic passive income into foreign income that is unrelated to its foreign business operations, and thereby escape domestic tax.

4.82   Canada now has three anti-deferral regimes that may apply to a taxpayer in respect of a foreign entity. These are:

• the FAPI regime,
• the foreign investment entity (FIE) regime, and
• the non-resident trust (NRT) regime.³⁷

4.83   The Panel heard that, despite some problems, the FAPI regime is well understood and accepted. However, as discussed below, serious concerns were expressed about the proposed FIE and NRT rules.

FAPI regime

4.84   To deter arrangements in which controlled foreign affiliates of taxpayers resident in Canada earn and accumulate passive income (and certain other business income) outside of Canada, the FAPI regime taxes such income on an accrual basis. This treatment allows foreign passive income to be taxed currently and foreign active business income to be tax-deferred in accordance with the tax policy underlying the current foreign affiliate regime.

4.85   Passive income earned by a foreign affiliate that is not a controlled foreign affiliate is not taxed on an accrual basis in Canada. Such income is still FAPI but it is currently subject to Canadian tax under the Credit Method on repatriation. This treatment reflects the view that if the Canadian shareholder does not control the foreign affiliate, there is less opportunity for tax avoidance and the Canadian shareholder should not be subject to tax on the income until it is received as a dividend.

FIE regime

4.86   Where a taxpayer has interests in non-resident entities that are not considered to be interests in foreign affiliates subject to the FAPI regime, the FIE regime is intended to produce a result similar to the FAPI regime. Since the FAPI regime taxes passive income earned by a controlled foreign affiliate on an accrual basis, the FIE regime should not apply to such interests.³⁸

4.87   The FIE regime applies to an interest of a taxpayer in a non-resident entity that is considered to be a FIE; any non-resident entity is a FIE unless it can be shown that either the entity’s principal undertaking is not conducting an investment business or that more than 50 percent of the carrying value of its property is not investment property. Once a non-resident entity is determined to be a FIE, the rules apply to the taxpayer in respect of its participating interests in the FIE.

4.88   The FIE regime is an all-or-nothing one: if the foreign entity is a FIE, there is no means to defer the taxation of active business income of the entity. Instead, all of the income of the entity or a proxy for its income attributable to the taxpayer’s interests in the entity is taxed on an accrual basis in Canada.

NRT regime

4.89   The NRT regime does not operate in the same way as the FAPI and FIE regimes; it does not attribute income of a non-resident entity to a taxpayer who has a beneficial interest in a non-resident trust. Rather, under certain conditions, the NRT regime treats a non-resident trust as being resident in Canada and treats the contributors and beneficiaries of the trust as being jointly liable, together with the trustee, for the Canadian tax of the trust.

4.90   A non-resident trust is deemed to be resident in Canada if there is a resident contributor or a resident beneficiary under the trust. This regime targets the use of non-resident trusts to earn income on behalf of Canadian residents. Certain family and other trusts are excluded from the rules.

Evaluating Canada’s current anti-deferral regimes

4.91   The anti-deferral rules are integral to Canada’s international tax rules and are needed to protect the Canadian tax base. While supporting the position that income from an active business earned by foreign affiliates should be exempt from Canadian tax, the Panel believes that passive income should be subject to Canadian tax to prevent its accumulation offshore where the taxpayer’s intent is to avoid Canadian tax. Simply put, the Panel believes there is no good tax policy reason to favour foreign over domestic passive income. The Panel believes that most Canadians share this view, and we encountered no contrary opinion during our consultations.

4.92   However, in accordance with the principles set out in Chapter 3, the concern with tax avoidance must be weighed against any compliance and administrative costs that may impede the ability of Canadian companies to compete in global markets.

4.93   Under the broader exemption system for active business income proposed by the Panel, there could be a tendency to introduce or extend complex rules to protect the Canadian tax base that would increase the compliance and administrative burden for taxpayers and the CRA. The Panel heard that Canada’s anti-deferral rules, especially the proposed FIE and NRT regimes, are already too complex. The Panel also heard that some aspects of the current anti-deferral rules overreach or overlap, diminishing the competitiveness of Canadian businesses.

4.94   The Panel believes that, to preserve the integrity of the Canadian tax base, some complexity in the anti-deferral regimes is inevitable. However, the Panel also believes that there is room to improve these rules.

Integrating the current anti-deferral regimes

4.95   Some complexity could be reduced by integrating the three anti-deferral regimes into one or two regimes.³⁹ Yet, while the Australian Government Board of Taxation recently acknowledged that Australia’s equivalent of Canada’s FAPI and FIE regimes could be better integrated, the Board recommended focusing reform efforts on desired outcomes and policy factors relevant to taxing passive foreign-source income on a current basis rather than on harmonizing the existing regimes.⁴⁰

4.96   Some commentators believe that it may be better to integrate at least the current FAPI and proposed FIE regimes to reduce complexity and overlap. However, integrating the two regimes may be difficult in part because the FAPI regime takes a “transactional approach” for taxing passive income while the FIE regime takes the “entity approach”.⁴¹

Controlled foreign affiliates

4.97   The Panel believes the FAPI regime’s current transactional approach is best suited to taxing passive income earned by controlled foreign affiliates. Use of an entity approach could ease the compliance and administrative burden on taxpayers and the CRA in quantifying the income that should be taxed in Canada on an accrual basis. However, the Panel believes that where planning steps are taken to reduce the passive income relative to income from the entity’s active business assets, such an approach might allow passive income of controlled foreign affiliates to escape Canadian tax. Further, if the passive income is substantial relative to the active income, the entity approach could cause certain active business income to be taxed currently as though it were passive income.

4.98   The Panel believes the compliance and administrative burden associated with the current FAPI regime is acceptable and necessary to protect the Canadian tax base, particularly given the Panel’s recommendation to move to a broader exemption system for foreign active business income. Moreover, businesses will benefit from reduced complexity in other areas, for example, with respect to surplus balances of foreign affiliates that no longer need to be tracked.

Non-controlled foreign affiliates

4.99   Under the current rules, FAPI of a non-controlled foreign affiliate is taxed under the Credit Method. It would be inappropriate to exempt such income from tax in Canada. If the government extends the existing exemption system to dividends received from foreign affiliates and for capital gains realized on the disposition of shares of foreign affiliates, thereby possibly eliminating the need to track surplus accounts, a solution must be found for taxing passive income earned by non-controlled foreign affiliates.

4.100   One approach would be to tax this income under a FIE regime. However, the Panel heard criticism about the complexity of the proposed FIE regime and the burden it places on Canadian businesses of all sizes.⁴² The Panel believes that the compliance burden for taxpayers and the administrative burden for CRA would increase significantly if the proposed FIE regime were to be relied upon to tax passive income of non-controlled foreign affiliates.

4.101   The Panel considered whether the existing FAPI regime should be extended to tax passive income of all foreign affiliates on an accrual basis while applying the FIE regime only where the non-resident entity is a FIE but not a foreign affiliate. This treatment would take a transactional approach to investments that qualify as foreign affiliates and an entity approach to portfolio investments. The bright-line distinction would eliminate overlap between the FAPI and FIE regimes by narrowing the scope of the FIE regime to entities that are not foreign affiliates.

4.102   The Panel recognizes that this approach is not as straightforward as it might seem, though it may have some support.⁴³ With respect to controlled foreign affiliates, Canadian taxpayers typically control or influence their affiliate’s investment in passive-type activities, including the timing of the repatriation of such income derived from such activities, and they are also in a position to access the information needed to compute the resulting FAPI that is subject to tax in Canada. However, Canadian investors in non-controlled foreign affiliates might not be able to obtain such information, or control or influence the level of investment in passive activities and the repatriation of the resulting income. If the FAPI regime were extended to all foreign affiliates, the manner in which the FAPI rules apply to non-controlled foreign affiliates may need to be modified.

Conclusion

4.103   The Panel believes that our recommendation to adopt a broader exemption system raises questions about the scope and interaction of Canada’s existing anti-deferral regimes. In particular, the Panel believes that the proposed FIE and NRT rules should be reconsidered to ensure that their need and scope are consistent with the Panel’s recommendations and the principles in Chapter 3 regarding the international taxation of outbound investments by Canadian businesses.

4.104   The Panel has concluded that the government should undertake a fresh review to coordinate the FAPI, FIE and NRT regimes. This review should aim to ensure all passive income is taxed on an accrual basis and to focus the scope of these rules so they do not impede bona fide commercial business transactions.

4.105   Also in line with the Panel’s principles, any proposed change to the scope and interaction of the anti-deferral regimes should undergo full consultation.

Recommendation 4.5: In light of the Panel’s recommendations on outbound taxation, review and undertake consultation on how to reduce overlap and complexity in the anti-deferral regimes while ensuring all foreign passive income is taxed in Canada on a current basis.

4.106   The Panel believes that this recommendation and those that follow in this section will reduce the complexity of these rules, ease the compliance and administrative burden on taxpayers and the CRA, and enhance the integrity of Canada’s international tax system.

Scope of the FAPI rules

4.107   As noted, the Panel observed a broad consensus regarding the appropriateness of the FAPI regime.

4.108   Over the years, the government has taken steps to strengthen these rules to deter the avoidance of Canadian taxation with respect to passive income earned by foreign affiliates.⁴⁴

4.109   A key issue is distinguishing between passive income, which should be taxed in Canada on an accrual basis, and foreign active business income, which the Panel proposes should be exempt from Canadian tax. The Panel heard concerns over the appropriateness and scope of certain aspects of the current rules for determining passive income that is taxed as FAPI.

Base erosion rules

4.110   The base erosion rules are intended to prevent the erosion of Canada’s tax base resulting when taxpayers divert income from Canadian-source activities to foreign jurisdictions. Such activities include the earning of income from the sale of property, interest and leasing income, insurance income and income from providing certain services. Under certain circumstances, such income will be treated as FAPI.

4.111   Base erosion rules are a feature of many other countries’ foreign affiliate regimes.⁴⁵ Historically, such rules were justified to protect the domestic tax base against situations where income is diverted to a foreign country where only nominal value-adding economic activities may be taking place.

Issues under the base erosion rules

4.112   The Panel heard that the scope of the current rules may be too broad and that the policy underlying these rules is outdated in certain situations.⁴⁶

4.113   This criticism is not surprising. The appropriateness of base erosion rules is being debated in a number of countries, particularly as many of them have the stated policy objective of increasing the global competitiveness of their domestic corporations. For example, the United States recently reviewed the impact of its base erosion rules (among others) on the competitiveness of U.S. businesses; and earlier this year proposed regulations were released that provide a relieving exception to those rules.⁴⁷ In March, the Australian Board of Taxation proposed to eliminate all of that country’s base company income rules concluding that such rules “increasingly place firms in Australia at a competitive disadvantage in overseas markets.”⁴⁸ New Zealand also acknowledged that it had heard that “some features of (its) proposed rules for taxing royalties and base company income would be burdensome and could inhibit active businesses.”⁴⁹ In July, New Zealand introduced a tax bill that included provisions scaling back its base erosion rules.⁵⁰

4.114   Critics argue that the base erosion rules are unnecessary, especially now that most countries have extensive transfer pricing rules in place to ensure that the profit allocated among the countries involved in a transaction is commensurate with the activity taking place within each country.⁵¹ Canada introduced a new transfer pricing regime in 1998 after its current base erosion rules were enacted.

4.115   More importantly, the Panel heard that certain of Canada’s base erosion rules prevent Canadian businesses from effectively managing their global supply chains. In current global business models used by many international businesses, few goods and services are typically produced entirely in one location. Businesses seek the best location to undertake each activity, whether design, engineering, manufacturing, marketing or after-sales service. International businesses now organize supply chains more efficiently, reducing costs and standardizing services and their delivery across business groups in many countries. Canadian and foreign businesses commonly have global framework agreements and centralized procurement arrangements for financial, technical, engineering, communications, information technology, marketing, management and other services.

4.116   Under global supply chain management, Canadian businesses can take advantage of cost savings associated with outsourcing and manufacturing abroad through foreign affiliates to enable them to compete more effectively globally.⁵² Canadian businesses may acquire foreign enterprises to enhance this process, which invariably results in Canadian businesses acquiring goods and services from their foreign affiliates and sometimes gives rise to FAPI under the current rules.

4.117   The Panel heard the following examples of situations of income being inappropriately subject to tax arising under the current FAPI regime.

• A Canadian company acquires a foreign company with special expertise. The foreign company carries on an active business, principally with third parties, but also provides some services to the Canadian company. Under the current rules, income from these services would be taxed in Canada on an accrual basis as FAPI.
• A Canadian investment fund manager acquires operations outside of Canada. The Canadian investment fund manager engages its newly acquired offshore affiliates to provide investment advisory services to its Canadian mutual funds. Under the current rules, the service fees paid to the offshore affiliates would be FAPI.⁵³
• A U.S. subsidiary of a Canadian parent can sell product it makes or sources in the United States to its Canadian parent without having the income on that sale considered FAPI. However, foreign businesses now commonly manufacture and source product in more than one jurisdiction. For example, assume the U.S. subsidiary assembles an aircraft using components made in the United Kingdom and Japan and sells the aircraft to its Canadian parent to on-sell to a client. In this case, the U.S. subsidiary’s income from the sale would be FAPI to the Canadian parent. Moreover, foreign multinationals may employ the same structure to sell to their Canadian subsidiaries to reduce their global costs and increase production efficiency, thereby gaining a competitive advantage relative to Canadian companies in the Canadian marketplace.⁵⁴

Investment business rules

4.118   Under the current rules, certain income from businesses carried on by foreign affiliates that might otherwise be considered to be active business income is instead treated as FAPI unless certain conditions are met. Such income includes income from businesses established principally to earn interest, dividends, rents or royalties or income from insurance or reinsurance, factoring and the disposition of certain properties.⁵⁵ For example, rental income derived by a foreign affiliate carrying on a large real estate business with hundreds of employees is considered active business income and not FAPI. However, interest income earned by an affiliate on bank deposits that represent amounts in excess of what is needed to run the affiliate’s active business is considered passive income and taxed as FAPI.

4.119   The Panel heard that certain tests providing exceptions from the investment business rules can be difficult to meet, causing otherwise active business income to be treated as FAPI.⁵⁶ For example, many real estate development, leasing, management and other global businesses linked to real property tend to be carried on in multiple foreign entities. This is done in many circumstances for non-tax reasons such as financing and raising capital, insurance, limiting legal liability, and creditor-proofing. In most cases, if all the relevant entities in the corporate group were treated as one taxpayer, there would be no doubt that the taxpayer would be considered to be carrying on an active business. The use of multiple entities can make it difficult for these businesses to meet the conditions necessary to ensure their income is treated as active business income and not FAPI.

Conclusion

4.120   In the Panel’s view, foreign active business income should not be taxable in Canada. The base erosion and the investment business rules are designed to restrict the exemption from Canadian tax to commercially-driven foreign active business income.

4.121   The Panel believes that Canada’s base erosion rules and the “investment business” definition should not target income arising from activities that are carried out for bona fide business reasons, enhance the competitiveness of Canadian companies in the global marketplace and do not aim to erode the Canadian tax base. The Panel acknowledges that this distinction can be difficult to make. The base erosion rules and the investment business rules must be continually revisited to ensure they remain properly focused as international business practices evolve.

4.122   The Panel heard that the base erosion rules are unnecessary in light of Canada’s transfer pricing rules. In the Panel’s view, transfer pricing rules pose administrative challenges. Well-designed and properly focused base erosion rules complement the transfer pricing rules and provide certainty about the types of income that should be subject to Canadian tax, without adversely affecting the global competitiveness of Canadian businesses.

4.123   For this reason, the Panel believes that base erosion rules which target income derived from Canadian debt obligations, Canadian leasing activities, and the insurance of Canadian risks are appropriate and should be retained.

4.124   However, the Panel believes that the base erosion rules (and the rules regarding the sales of goods and services between foreign affiliates carrying on active businesses) are not appropriate to the extent they impede the efficient business operations of Canadian companies. While acknowledging that certain relieving provisions have been introduced in recent years to prevent certain of these types of income from being treated as FAPI, the Panel believes more can be done.

Recommendation 4.6: Review the scope of the base erosion and investment business rules to ensure they are properly targeted and do not impede bona fide business transactions and the competitiveness of Canadian businesses.

4.125   The Panel also submits that if the FAPI regime is extended to non-controlled foreign affiliates, the government should consider the extent to which the base erosion and investment business rules would apply differently to non-controlled foreign affiliates.

Inter-affiliate payments

4.126   Special exceptions to the FAPI rules may apply in the case of interest, royalties and certain other payments received by one foreign affiliate from another where, as described earlier, the Canadian shareholder has a qualifying interest in the payor and payee affiliates. For example, interest income of a foreign affiliate received from another foreign affiliate is not considered FAPI if the second affiliate deducted the interest in computing its active business income (among other conditions). This exception is referred to as the “inter-affiliate payment exception” and is used by many Canadian companies to structure and finance their foreign operations efficiently and tax-effectively.

4.127   The United States has adopted a temporary rule similar to Canada’s. U.S. corporations can also achieve the same effect using the “check-the-box” rules described in the box on page 51. Other countries, such as Australia (and New Zealand under current proposals), have similar rules but restrict their application to payments between affiliates within the same country.

4.128   The Panel strongly believes that Canada should retain its current rule that treats such payments between affiliates, which would otherwise be FAPI, as income from an active business. In the Panel’s view, this rule preserves the underlying character of active business income that is the source of the inter-affiliate payment and minimizes the situations where these payments attract Canadian tax under the FAPI regime. Eliminating this rule would impair the competitiveness of Canadian companies relative to other foreign companies that benefit from the same or similar rule in their home country.

4.129   The Panel believes that a “same-country exception”, like that in place in Australia, suffers from the same limitation as certain current base erosion rules — it does not acknowledge that companies operate globally and do not carry on all of their active operations within a single country or entity. Moreover, given that the Panel recommends that Canada cede taxation of foreign active business income to the foreign-source country without condition, how Canadian multinationals structure their foreign operations within or between foreign jurisdictions to minimize foreign income tax on their active business earnings should be irrelevant from a Canadian tax perspective. Adhering to this principle provides the flexibility that businesses need and appropriately treats separate foreign entities within a corporate group as a single entity carrying on an active business.

Possible exemption for passive income earned in high-tax countries

4.130   The Panel considered whether it would be appropriate to exempt passive income from current taxation under the FAPI (and possibly the FIE) regime if the income of the entity was subject to a certain level of foreign tax or if it was earned in a particular designated jurisdiction. Relief is already provided under Canada’s FAPI rules for foreign taxes paid in respect of FAPI (and also would have been provided for under the FIE regime upon a distribution of FIE income, had the proposed new rules been enacted as drafted). Thus, such an exemption should be revenue-neutral while presumably easing compliance and administration for taxpayers and the CRA.

4.131   The Panel identified some potential problems with this approach. First, it may be necessary for taxpayers to ensure that the passive income has been subject to foreign tax, which may not reduce complexity as intended. Secondly, if establishing whether the passive income was actually subject to a certain level of foreign tax were not required, there would be an incentive to move passive investment assets to high-tax foreign countries where the passive income could be sheltered by active business losses or by tax avoidance transactions not subject to anti-avoidance rules.

4.132   The Panel nonetheless believes this approach deserves further consideration, particularly if the FAPI regime is extended to non-controlled foreign affiliates. Such treatment could greatly reduce the compliance and administrative burden for taxpayers and the CRA, especially where, for example, the foreign entities reside in the United States. This approach would also free the CRA to focus more on passive income earned by foreign entities in low-tax jurisdictions.

De minimis rule

4.133   Under the current rules, a Canadian shareholder of a controlled foreign affiliate that earns up to $5,000 of FAPI is not subject to Canadian tax on an accrual basis.

4.134   The de minimis exception under the FAPI regime is a bright-line test that reduces the compliance burden for all businesses, especially small businesses. It prevents the FAPI rules from applying to foreign affiliates that conduct genuine businesses abroad but derive only small amounts of passive income as part of that business. It also allows the CRA to focus its risk assessment and enforcement activities on businesses that earn material amounts of FAPI.

4.135   Other countries, including the United States, the United Kingdom, Germany and Australia, exclude a de minimis amount of passive income of a controlled foreign corporation from accrual basis taxation.

4.136   The Panel believes that a de minimis exclusion is appropriate and that Canada should retain its current approach because of the simplicity and certainty it provides to Canadian businesses. The threshold has not increased since its introduction in the mid-1970s. The Panel heard that the de minimis threshold should be higher, and the Panel believes increasing the threshold would help smaller businesses with foreign operations.

4.137   The Panel considered whether the de minimis threshold should be indexed to inflation. Although indexation would be consistent with Canada’s general tax policy, it would add a degree of complexity. The Panel does not recommend that the threshold be indexed each year; however, the threshold should be reviewed periodically to ensure it continues to meet its policy objectives. At this time, the Panel encourages the government to increase the de minimis threshold.

4.138   The Panel also believes that serious consideration should be given to providing a de minimis threshold in the context of the FIE and NRT regimes. Such an exemption could apply to an investment that is less than a certain dollar amount.

[TOP]    [CONTENTS]

Expenses incurred to earn foreign-source income

Introduction

4.139   Under any tax regime that exempts foreign active business income from domestic taxation, it is necessary to ensure that such income is properly measured. For example, Canada’s FAPI regime must ensure that passive-type income is not included in the computation of foreign active business income. A more difficult issue in measuring foreign active business income is the treatment of expenses incurred by a domestic company that may be considered to relate, directly or indirectly, to the earning of foreign active business income.

4.140   This section focuses primarily on interest expense incurred by Canadian companies to invest in foreign affiliates. It also addresses the treatment of interest expense in the context of outbound financing arrangements; these so-called double-dip financing arrangements enable interest expense to be deducted in two jurisdictions while offsetting interest inclusion is taxed elsewhere at a lower rate, or not at all. Later in this section we consider the tax treatment of expenses other than interest.

Treatment of interest expense

4.141   In reviewing this contentious area of international taxation, the Panel assessed several concepts applicable to the treatment of interest expense and considered Canada’s historical policy objectives. As noted at paragraphs 3.5 and 3.6 and as embodied in the principles enunciated at paragraph 3.3, Canada’s goal has been to achieve a tax system that does not harm the competitiveness of Canadian businesses when investing abroad, accords with international norms, and protects the Canadian tax base. The Panel also considered the impact of the recent global financial crisis on Canadian businesses.

4.142   Current Canadian income tax rules permit the deduction of interest incurred by a Canadian resident taxpayer with respect to funds borrowed to invest or acquire shares in a domestic or foreign company, even though dividend income earned on such shares may not be subject to Canadian tax. Many countries have a similar general rule. In this section, we explore the tax policy basis for the treatment of interest arising from arm’s-length debt where the proceeds are invested in foreign companies and through outbound financing arrangements.⁵⁷

4.143   The deductibility of interest expense for Canadian tax purposes on amounts borrowed to invest in foreign affiliates and finance foreign acquisitions is especially challenging. For example, one view is that it is consistent with the matching principle to deny deductions on interest incurred to make outbound investments that will yield dividend income not subject to domestic tax.⁵⁸ Another view is that outbound investment increases domestic investment and the domestic tax base overall,⁵⁹ and so the additional tax revenues that result provide a basis to support the deductibility of interest incurred to invest abroad.

Other countries’ approaches

4.144   Many countries are devoting more attention to the deductibility of interest in general.

The increase in interest deductibility limitations is mostly driven by (a) academics’ recommendations that debt and equity financing be treated equally; (b) the European Court of Justice (ECJ) requirement to treat equally domestic and foreign borrowing and use of borrowed funds; (c) tax collectors’ increasing fear of tax base erosion; and (d) a tendency to massively reduce statutory tax rates while broadening the tax base. With regard to tax base erosion, in particular extremely leveraged and often hybrid financing of private equity acquisitions is targeted by tighter interest deduction rules.⁶⁰

4.145   Many of the recent changes in European Union (EU) countries in this area stem from a need to accommodate decisions of the ECJ. The ECJ has held that under EU law the tax systems of the EU countries must not discriminate against investments in other EU countries. For example, rules that permit an interest deduction on money borrowed to invest in shares of a domestic company but restrict an interest deduction on money borrowed to invest in another EU company do not accord with EU law.⁶¹ For the same reason, thin capitalization regimes that apply only to domestic companies under foreign control also contravene EU law.⁶²

4.146   Some countries that use the Credit Method, including the United States and the United Kingdom, neither immediately nor specifically restrict the deductibility of interest expense incurred to earn income from a foreign company. Under U.S. law, costs incurred to earn foreign-source dividends are allocated to that income in determining how much foreign tax can be claimed as a credit against domestic tax when dividends are received in the United States from foreign affiliates. Although the amount of foreign tax that can be claimed as a credit is indirectly limited by the allocation of previously deducted interest to the foreign-source dividend, interest on money borrowed to invest in foreign companies is deductible for U.S. tax purposes on a current basis without restriction.

4.147   Moreover, the foreign tax credit limitation is not relevant as long as the foreign-source income is not repatriated. Prolonged deferral in paying dividends allows U.S. businesses to achieve a result comparable to what is available to Canadian businesses under Canada’s current system.

4.148   Some countries with exemption systems, such as France, the Netherlands and Sweden,⁶³ do not restrict deductions for interest on arm’s-length borrowings invested in foreign company shares that will produce exempt dividend income. However, France exempts only 95 percent of foreign qualifying dividends — the other five percent is considered to be a proxy for expenses incurred that relate to such income. A recent announcement by the Norwegian government proposes to exempt 97 percent of foreign qualifying dividends.⁶⁴

4.149   Some countries allow deductions for interest, subject to general interest-deductibility restrictions that can apply to arm’s-length interest paid on money borrowed to invest in foreign affiliates. For example, Australia has introduced a regime that applies to all debt of foreign-controlled Australian companies as well as Australian companies with foreign subsidiaries. Germany has introduced earnings stripping rules which can apply to arm’s-length interest on borrowed money used to invest in foreign companies.

Lessons from other countries

4.150   In short, the Panel’s benchmarking shows that many countries permit an interest deduction on money borrowed for foreign investment. The following comments aptly summarize what we found in our research and heard in our consultations.

Canadian companies compete against enterprises based in countries whose international tax systems accommodate double dips and contain other mechanisms that facilitate lower effective tax rates on foreign earnings. Although some countries have introduced a comprehensive interest deductibility rule (e.g., Australia, Germany), it is not yet a widespread development. If more countries shifted their tax systems to this type of rule, and if the United States tightened its international tax system, Canada might then consider similar changes. In the meantime, there is little to be gained by moving early.⁶⁵

4.151   The Panel recognizes that permitting a deduction for interest expense to earn exempt foreign dividends may not be consistent with the matching principle. Nonetheless, for competitiveness reasons, the approach of permitting the deduction has been accepted within the Canadian system for many years.

(I)nternational norms are largely responsible for the policy not to specifically restrict the deductibility of interest expense on money borrowed to invest in a foreign affiliate. Ultimately, Canada finds itself in the position of having to balance tax theory with the economic realities of the international marketplace…. (T)he government’s policy has generally been to favour competitiveness concerns over those of revenue generation.⁶⁶

4.152   Perhaps more importantly, the international financial market outlook has changed dramatically since August 2007. The world faces unprecedented challenges, particularly regarding credit, liquidity and market risk. Many economies are in or are threatened by what is possibly one of the most serious recessions in recent memory. Many governments have felt compelled to intervene in their free market economies. While Canada’s prudent regulatory and fiscal policies have enabled the nation to avoid the worst of these difficulties, we are not immune from spillovers from jurisdictions that have suffered more severely. As a result, Canadian businesses face credit and other challenges to their ability to compete outside Canada and invest in future growth.

4.153   The guiding principles of tax policy are not dependent on the ebb and flow of the marketplace. Canadian businesses must compete in global markets at all times; however to hobble their ability to compete and invest in the future at the worst of times would not be consistent with the principles guiding our analysis. It is clear that businesses in many of Canada’s trading partner nations are not restricted in their ability to deduct interest expenses incurred to invest in foreign affiliates and use various outbound financing arrangements as discussed later in this section.

4.154   The Panel believes that the principles of competitiveness and benchmarking set out in Chapter 3 continue to provide guidance in these times of international economic stress. Prudent policy, cautious stewardship, and management of the risks to the Canadian economy that are within the federal government’s ability to act on, are also critical. The success of Canadian businesses operating abroad, and the Canadians they employ, must be considered when making choices about tax measures that could undermine the ability of these businesses to compete.

4.155   For these reasons, the Panel does not believe that there should be any restrictions on the deductibility of interest expense incurred by Canadian companies to invest in foreign affiliates.

Outbound financing arrangements

4.156   This section deals with interest deductibility in the context of outbound financing arrangements. These arrangements are widely used by multinational companies to structure their international investments. They are designed to efficiently finance acquisitions and expansion abroad and can lead to low foreign tax rates on specific sources of foreign income. Recently, Canada passed new targeted legislation⁶⁷ that aims to curtail the use of such structures by Canadian companies.

4.157   Some tax policy specialists argue that rules aimed at eliminating double-dip structures are inappropriate, because these financing arrangements reduce foreign tax payable, not Canadian tax. On this view, Canadian tax policy should focus on measuring and taxing Canadian source income, and the Panel has focused on this point. Others argue that such rules are important for ensuring that Canadian domestic investment does not bear a higher tax cost than foreign investment. The Panel believes these issues should be addressed pragmatically and with guidance from the principles regarding competitiveness and benchmarking set out in Chapter 3.

4.158   The United States has introduced new rules that affect interest deductions for cross-border investments. These “dual consolidated loss” rules address a broad range of situations where a single economic loss is deducted twice. In 2005, the United Kingdom introduced “anti-arbitrage” rules targeting structures involving hybrid entities and hybrid instruments. The scope of the UK rules is broad, and they can apply to certain outbound financing structures.⁶⁸

4.159   However, for companies based both in the United States and the United Kingdom, these rules do not result in the elimination of such arrangements and U.S. and UK-based companies can still make use of tax-effective outbound financing arrangements. While there are likely many different ways in which companies based in these two countries can structure outbound financing arrangements, the box on the previous page provides some examples.

4.160   The Panel has noted recent tax treaty developments that aim to deny the benefits of certain cross-border financing arrangements. For example, in 2001, the United States and the United Kingdom agreed to a provision in their tax treaty to reduce the effectiveness of certain financing transactions used by UK companies to finance their U.S. operations.⁷¹ More recently, the fifth protocol to the Canada-U.S. tax treaty⁷² introduced rules that reduce the effectiveness of certain cross-border financing arrangements. Despite these measures, cross-border financing arrangements remain possible between the United Kingdom and the United States and between the United States and Canada.

4.161   Other countries, such as the Netherlands and Sweden, do not have any targeted domestic measures to restrict interest expense where money is borrowed from an unrelated party for use in outbound financing arrangements.

4.162   Foreign affiliate regimes that are tightly controlled can be viewed as substitutes for targeted interest restriction rules. For example, France’s controlled foreign corporation (CFC) regime attributes all the income of a foreign entity to the French parent where the foreign entity is subject to a tax rate that is 50 percent or less than France’s rate on similar income.⁷³ At first glance, such a system would seem to deter the use of outbound structured financing arrangements. However, the French CFC regime does not apply to a foreign entity established or resident in an EU Member state. Thus, French CFC rules may not apply to an Irish entity that may be taxed at a rate which is less than 50 percent of France’s 33.33 percent corporate tax rate. An exception allows the French tax authorities to apply the CFC rules if they can show that the establishment in the other EU state is an artificial scheme designed to skirt French tax law.⁷⁴ However, based on recent ECJ decisions, it may be relatively easy for companies to stay clear of what is considered “artificial”.⁷⁵

4.163   It is clear that other countries have not eliminated the use of outbound financing arrangements. Competitors of Canadian businesses based in other countries are able to make use of such arrangements to finance foreign acquisitions and expansions tax-effectively.

Conclusion

4.164   Interest deductibility was raised as an issue at every consultation meeting and in many submissions to the Panel. Members of the business community strongly oppose any restriction on interest expense incurred to invest in foreign affiliates.

4.165   Our research shows that many businesses based in other countries can deduct interest on money borrowed to invest in a foreign company even though dividends from the foreign company, when repatriated, will be either exempt or mostly free from home country tax. While some countries have introduced targeted rules aimed at restricting outbound financing arrangements, many such arrangements remain widely available. The Panel believes that Canada’s tax system should not create disadvantages for Canadian businesses when they compete abroad.

4.166   Canadian businesses need flexibility in raising capital and structuring the financing of their foreign acquisitions and expansions to be competitive with businesses based in other countries. In the Panel’s view, this pragmatic concern is of greater weight than the theoretical basis for denying interest deductions on money borrowed to invest in foreign companies or in respect of outbound financing arrangements.

4.167   As noted at paragraphs 4.152–4.154, events in the current global financial environment highlight how quickly capital markets can change and how adaptable Canadian companies need to be. Since summer 2007, the manner in which financial market participants evaluate credit, liquidity and market risk has shifted dramatically. Due to changes in the conditions that affect capital markets for Canadian and global businesses, debt placement is much less flexible. The Panel acknowledges that although arguments exist for rules that deny interest deductibility on borrowings related to investments in foreign affiliates or in respect of outbound financing arrangements, now is not the right time to impose rules that could restrict access to capital for Canadian companies, especially when international tax rules in many other countries support the deductibility of interest for investments and arrangements.

Recommendation 4.7: Impose no additional rules to restrict the deductibility of interest expense of Canadian companies where the borrowed funds are used to invest in foreign affiliates and section 18.2 of the Income Tax Act should be repealed.

Treatment of expenses other than interest

4.168   For Canadian tax purposes, a business can deduct reasonable expenses in computing its income only to the extent they are incurred to earn or maintain such income, subject to certain exceptions and conditions.

4.169   Often one member within a corporate group will incur general and administrative expenses (including stewardship costs) and other costs related to services it provides for the group’s benefit. The member cannot deduct from its income expenses that it incurred that should be reimbursed by others in the group. Thus, the payer will either on-charge the expenses to the companies that benefited from the services or will enter into cost-sharing arrangements at the outset if the benefits (or risks) of the expense are mutual (for example, when sharing research and development costs). Such charges usually include all direct and indirect costs, and they may be marked up or computed using a formula.

4.170   These general and administrative expenses relate to a range of services from human resources to advertising and insurance. Their recovery can be complex, but the approach to their recovery is simple: those who benefit from the expenses incurred by another must pay for them to the extent of that benefit. This approach protects Canada’s tax base by preventing a tax deduction to the extent that the expenses do not relate to the business activities of the person that incurred the cost, thereby ensuring that person’s income is properly measured.

4.171   Canada’s rules for recovering expenses other than interest appear to operate reasonably well. Moreover, most countries that use an exemption method take a similar approach: such expenses are deductible if they are incurred to earn or maintain taxable income, and there are no detailed tracing or allocation rules to determine if these expenses relate to exempt foreign-source dividends and capital gains.⁷⁶

4.172   Like Canada, these other countries rely on their general approach and on their transfer pricing rules, which require that intra-group charges reflect arm’s-length pricing to properly measure domestic source income. This is largely a transfer pricing issue and is addressed in Chapter 7.

4.173   The Panel has concluded that Canada’s current tax treatment of intra-group expenses works reasonably well and sees no compelling reason for additional rules.⁷⁷

 

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²⁶ A controlled foreign affiliate is a foreign affiliate that is controlled by a Canadian resident or a small group of Canadian residents. In determining whether a foreign corporation is a controlled foreign affiliate, there are additional rules that include shares owned by related or non-arm’s-length persons.

²⁷ For Canadian corporations, the gain can be reduced by any undistributed earnings of the disposed affiliate.

²⁸ The tax regimes of Australia, France, Germany, Italy, the Netherlands and Sweden each provide for some level of exemption, in certain circumstances, for dividends from foreign corporations. Currently, 21 of 30 OECD countries use an exemption system. The United Kingdom, Japan and New Zealand have proposed or are considering moving to exemption regimes.

²⁹ On this view, the exemption of dividends from foreign active business income would not be considered a tax preference or “tax expenditure”. The Department of Finance report, Tax Expenditures: Notes to the Estimates/Projections — 2004 (Ottawa: Public Works and Government Services Canada, 2004, at p. 7) describes tax expenditures as special tax rates, exemptions, deductions, rebates, deferrals and credits that have an impact on government revenue (that is, they have a cost) and reflect the government’s policy choices. The report states that in order to define tax expenditures, it is necessary to establish a “benchmark” tax structure that applies the relevant tax rates to a broadly defined tax base — for example, personal income, business income or consumption. Tax expenditures are then defined as deviations from this norm.

³⁰ Surplus balances are also relevant under current domestic rules for tracking “safe income” of Canadian companies. See Appendix B.

³¹ This range was established by the Panel using Statistics Canada data (Cansim Tables 376-0051 and 376-0064). Statistics Canada country breakdown of Canadian direct investment abroad reflects the countries where funds are first invested and does not take into account funds subsequently redirected to another country.

³² Organisation for Economic Co-operation and Development, Model Agreement on Exchange of Information on Tax Matters (Paris: OECD, April 2002).

³³ Special provisions in the Act may apply to reduce or deny the loss otherwise determined.

³⁴ Australia has in place a similar system that taxes gains on sales of domestic company shares while exempting gains on sales of foreign affiliate shares.

³⁵ When a Canadian shareholder has a direct or indirect interest in an affiliate that represents at least 10 percent of its voting shares and the fair value of its assets, the shareholder is said to have a “qualifying interest” in that affiliate. The role of these inter-affiliate payments within the exemption system and the FAPI regime is discussed below in paragraphs 4.126 to 4.129.

³⁶ Report of the Technical Committee on Business Taxation, at p. 6.10.

³⁷ Proposed new rules on foreign investment entities and non-resident trusts were announced in the February 1999 budget. The effective date of the proposed new rule was postponed as the legislative process unfolded. Draft legislation was released in August 2001, and a detailed Notice of Ways and Means was tabled in October 2003. Revised draft legislation was released in July 2005. In November 2006, the proposed new rules were given first reading in the House of Commons as Bill C-33 (which lapsed when Parliament was prorogued in September 2007). The proposed new rules were reintroduced in October 2007 in Bill C-10 and quickly moved from the House of Commons to the Senate for approval. However, Bill C-10 lapsed when a general election was called for October 14, 2008. In this report, any reference to the existing rules means those that are enacted, and any reference to the proposed new rules means the proposals as they read in Bill C-10.

³⁸ One exception is for indirect interests in property defined as “tracked property.” The FIE regime’s tracked property rules can apply to shares of a controlled foreign affiliate if their value tracks certain investment properties of the affiliate.

³⁹ For a discussion of reform options, see Arthur J. Cockfield, Examining Policy Options for the Taxation of Outbound Direct Investment, research report prepared for the Advisory Panel on Canada’s System of International Taxation (September 2008), at section 4.4.1.

⁴⁰ Australian Government, The Board of Taxation, Review of the Foreign Source Income Anti-Tax-Deferral Regimes (January 2008), at p. 2.

⁴¹ Under a “transactional” approach, taxation rules apply based on the active or passive character of income derived from a particular transaction; under an “entity” approach, taxation rules apply based on the composition of the assets from which the entity principally derives its income and gains.

⁴² Similar concerns were expressed about the NRT regime.

⁴³ In its submission to the Panel, the Canadian Life and Health Insurance Association remarked at p. 13 that a measure that would reduce unnecessary complexity “would be to lower the threshold for ‘controlled foreign affiliate’ status to broaden the scope of the foreign accrual property income rules, which are time-tested and understood by taxpayers.”

⁴⁴ See in particular the amendments to the foreign affiliate rules released on January 23, 1995 and further modified by minor changes contained in Bill C-70 (part II), tabled in the House of Commons on February 16, 1995. While these amendments did not make any fundamental changes to the foreign affiliate regime (as it was at the time), they did address a number of technical deficiencies and thus have significantly affected many taxpayers.

⁴⁵ These rules or parts thereof are also referred to as “base company income” and can also include income from the sale of goods and services provided by one foreign affiliate to another.

⁴⁶ See submissions from the Canadian Bankers Association, the Joint Committee on Taxation of The Canadian Bar Association and The Canadian Institute of Chartered Accountants, KPMG LLP, Deloitte & Touche LLP, Telus Corporation, and Thorsteinssons LLP.

⁴⁷ See Joint Committee on Taxation, The Impact of International Tax Reform: Background and Selected Issues Relating to U.S. International Tax Rules and the Competitiveness of U.S. Businesses (JCX-22-06) (June 22, 2006). On February 27, 2008, proposed regulations were released that would modify the “manufacturing exception” to what constitutes foreign base company sales income for purposes of subpart F of the U.S. Internal Revenue Code.

⁴⁸ Australian Government, The Board of Taxation, op. cit., at p. 37.

⁴⁹ Speech by the Honourable Peter Dunne, Minister of Revenue, to the International Fiscal Association Conference 2008, Christchurch, New Zealand, March 14, 2008.

⁵⁰ New Zealand, Taxation (International Taxation, Life Insurance, and Remedial Matters) Bill, July 2008.

⁵¹ Others disagree, however: the submission to the Panel of the Chaire de recherche en fiscalité et en finances publiques of the Université de Sherbrooke cautions that base erosion rules should be maintained as a backstop to the transfer pricing rules (at p. 17).

⁵² Submission of the Conference Board of Canada to Canada’s Advisory Panel on International Taxation, at p. 2.

⁵³ Submission of the International Funds Institute of Canada to Canada’s Advisory Panel on International Taxation, at pp. 1-2. Conversely, when a Canadian investment fund manager provides services to a non-resident, there is a risk that the non-resident might be viewed as carrying on business in Canada. Recognizing this measure of uncertainty for non-residents vis-à-vis their Canadian investment activities, the government introduced section 115.2 which deems a non-resident not to be carrying on business in Canada so long as certain conditions are met. Technical issues related to these conditions are discussed in Appendix B.

⁵⁴ Submission from Deloitte & Touche LLP to Canada’s Advisory Panel on International Taxation, at p. 6.

⁵⁵ Subject to the exception described in the next section.

⁵⁶ In particular, the test requiring that more than five employees be employed full-time by the affiliate in the conduct of its active business was brought to the Panel’s attention.

⁵⁷ This section of the report does not address non-arm’s-length borrowings or the limited circumstances in which certain anti-avoidance rules could apply. For example, Canada has a targeted anti-avoidance rule that could apply where a taxpayer borrows funds in “weak currency” and converts those funds into another currency that is used to earn income.

⁵⁸ James R. Hines Jr., The Tax Treatment of Expenses Incurred to Earn Foreign Source Income: Principles, Policies and Options (August 2008), research paper prepared for the Advisory Panel on Canada’s System of International Taxation.

⁵⁹ James R. Hines Jr., “Reconsidering the Taxation of Foreign Income”, paper presented at the 38th Annual Spring Symposium and State-Local Tax Program of the National Tax Association held in Washington, D.C. on May 15-16, 2008, at p. 22.

⁶⁰ Pascal Hinny, “New Tendencies in Tax Treatment of Cross-Border Interest of Companies”, Cahiers de droit fiscal international (vol. 93b), 2008 Brussels Congress of the International Fiscal Association (IFA), General Report (Rotterdam: Sdu Fiscale & Financanciële Uitgevers, on behalf of IFA, 2008), at p. 24.

⁶¹ Bosal Holding BV v. Staatssecretaris van Financiën (No. C-168/01), [2003] ECR I-09409.

⁶² Lankhorst-Hohorst GmbH v. Finanzamt Steinfurt (No. C-324/00), [2002] ECR I-11779. For a statement about the consequences to EU member states applying thin capitalization rules, see “C.F.E. Comments on Lankhorst-Hohorst GmbH, C-324/00”, submitted by the Confédération Fiscale Européenne to the Council, the European Commission, the European Parliament and the European Court of Justice in 2003.

⁶³ Sweden’s latest proposals would deny interest deductions on loans from affiliated companies in cases where the loans are for the acquisition of shares from an affiliated company. Under these revised proposals, interest arising from intra-group loans for the acquisition of shares directly from external parties would not be affected nor would interest on loans from arm’s-length persons. For details, see Ernst & Young LLP, International Tax Alert (26 August 2008); and KPMG Bohlins AB, KPMG TaxNews, issue no. 10 (August 2008) and issue no. 14 (September 2008).

⁶⁴ Royal Norwegian Ministry of Finance, National Budget 2009, presented to the Storting as Report no. 1 (2008-2009) (October 7, 2008). For summaries of this budget’s international tax proposals in English, see PricewaterhouseCoopers LLP, International Tax Services – European Tax, Newsalert (October 9, 2008) and Tax Notes International (October 13, 2008), at p. 113.

⁶⁵ Submission of Deloitte & Touche LLP to the Advisory Panel on Canada’s System of International Taxation, at p. 9.

⁶⁶ Response from the Department of Finance to the Auditor General, Report of the Auditor General 1992, Chapter 2, “Other Observations”.

⁶⁷ Section 18.2 of the Act.

⁶⁸ HM Revenue and Customs, “Avoidance Involving Tax Arbitrage”, guidance on the Finance (No. 2) Act 2005, at pp. 5-8.

⁶⁹ See United States, Joint Committee on Taxation, The U.S. International Tax Rules: Background and Selected Issues Relating to the Competitiveness of U.S. Businesses Abroad, July 15, 2003, p. 34. While the U.S. government has at times suggested these arrangements would be curtailed (see, for example, Notice 98-11, 1998-6 I.R.B. 18 (January 16, 1998) and Notice 98-35, 1998-27 I.R.B. 35 (June 19, 1998)), this has not occurred (see Internal Revenue Bulletin No. 999-30 (July 26, 1999)). In any event, the adoption of the temporary look-through rule discussed above suggests that such planning remains acceptable.

⁷⁰ The UK government is aware of such planning and is consulting with business about the reform of the entire UK system for taxing foreign-source income. See the HM Treasury Technical Note, available at www.hm-treasury.gov.uk/d/foreignprofits_technicalnote210708.pdf

⁷¹ Convention between the Government of the United States of America and the Government of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and on Capital Gains, signed at London, UK on July 24, 2001 (the “U.S.-UK tax treaty”), as amended, article 24(4)(c).

⁷² Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital, signed at Washington, D.C. on September 26, 1980 (the “Canada-U.S. tax treaty”), as amended by the Protocols signed on June 14, 1983, March 28, 1984, March 17, 1995 and July 29, 1997. The treaty was further amended by a Protocol signed September 21, 2007 (the “fifth protocol”). See articles IV(6) and (7) of the Canada-U.S. tax treaty as amended by the fifth protocol.

⁷³ Deloitte & Touche LLP, Tax Treatment of Expense Attributable to Foreign Source Income in Selected Countries (May 2008), report prepared for the Advisory Panel on Canada’s System of International Taxation.

⁷⁴ Ibid.

⁷⁵ In Cadbury Schweppes plc and Cadbury Schweppes Overseas Ltd. v. Commissioner of Inland Revenue (C-196/04), a UK public company, Cadbury Schweppes plc, established subsidiaries in Ireland, which benefited from a low-tax (10 percent) regime, for the purpose of performing group financing functions. The ECJ held that the UK CFC regime should not apply where a CFC located in another EU member state (i.e., the Irish subsidiaries) carries on genuine economic activities, despite the existence of tax-driven motives. The ECJ held that CFC rules could apply to foreign subsidiaries where the arrangement was wholly artificial.

⁷⁶ A few countries that use the territorial method, such as France, Germany and Italy, impose rules on the disposition of affiliates and receipt of dividends that effectively recapture a small percentage of deducted expenses. Countries that employ a credit method tend to have allocation or formulary apportionment rules for expenses related to foreign-source income, which are used in foreign tax credit calculations. How these rules operate to indirectly limit interest expense are discussed at paragraphs 4.146-4.147.

⁷⁷ The Technical Committee on Business Taxation reached the same conclusion. See Report of the Technical Committee on Business Taxation, at p. 6.19.

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